Hey, Where Is Everybody Going? The Flight from Healthcare Investing
If you are simply reading the paper or engaging in any random cocktail party conversation these days, it doesn’t take long before you are reading or talking about healthcare. Health and healthcare issues have been a dominant topic in the national media since the 2008 Presidential election and have been constantly in the news as the Patient Protection and Affordable Care Act (PPACA) has taken center stage. Even if PPACA weren’t always in the headlines, stories about employers who are grasping for solutions to their healthcare cost crises would still be.
Given the massive amount of change currently underway in the U.S. healthcare economy that has resulted from PPACA, the earlier healthcare IT stimulus legislation (ARRA) and the acts of employers saying that they’re mad as hell and not going to take it anymore, we have bona fide industry upheaval on our hands. And where there is upheaval, there is opportunity. Today more than ever there is a tremendous opportunity to find new ways of doing business in the world of healthcare through changing delivery systems, insurance models, technology solutions, drug discovery, device innovation and just about everything else that takes place in the healthcare system. Never before has there been so much energy and so much necessity to produce innovation in our field.
So given this, why are venture capitalists in the healthcare field fleeing like female co-workers from Herman Cain? Historically the source of funding for so much innovation and employment in the healthcare field, venture capitalists with lengthy histories funding the drug, device, service and IT companies of tomorrow are picking up their marbles and going home. Last guy out turn out the lights.
Last week the National Venture Capital Association (NVCA) said the following in their blog:
“…today we can say officially that we are seeing an alarming trend in the area of life sciences investing with the announcement that Scale Venture Partners will cease healthcare investing permanently. This exit follows the announcement last week that long time, established funds Morgenthaler and Advanced Technology Ventures would be effectively spinning out their healthcare investment practices and the announcement just over a month ago that Prospect Ventures would not raise a fourth healthcare fund and return committed capital to limited partners.”
What they didn’t include in their article were the additional facts that Highland Capital Partners recently decided to cut back its healthcare practice, CMEA Ventures has decided to make no more medical device investments and that Versant Ventures appears to be on the verge of reducing its healthcare practice if the industry buzz is correct. There are rumors afoot that a slew of others firms on Sand Hill Road are in the process of divesting themselves of their healthcare practices and there are several others that I know for sure already have taken steps in this direction but have not yet announced it formally.
To add to the pile, the NVCA released a report in October called Vital Signs. The report documents a survey that found that U.S. venture capital firms have been decreasing their investment in biopharmaceutical and medical device companies over the past three years and are planning to decrease their commitments to these areas even more. 39 percent of the 150 firms surveyed report decreasing their investments in life sciences companies over the last three years and the same percentage expect to further decrease these investments over the next three years, some by greater than 30 percent. According to NVCA, this is twice the number of firms that plan to increase healthcare investments.
Given this, I suppose the mass extinction we are now watching is predictable, if sad. It is certainly possible there was too much capital chasing healthcare deals, but now we are likely to swing too far in the other direction. Also, I know the people at most of these firms—great investors like Mark Brooks (Scale), Rod Altman (CMEA) and Bijan Salehizedah (Highland)–and they are smart, successful and have contributed greatly to the establishment of important healthcare companies that have become leading industry players. It is really a drag to see them heading into a game of musical chairs where someone has already taken all the chairs away. Hopefully all the really good ones will rapidly be back in active investing action before long.
Most of the firms who are jettisoning healthcare are planning to spend all of their capital on information technology deals. Because the world needs another Zynga and Groupon. Not. I mean, I get it. You can build these companies with no significant regulatory entanglement, grow them rapidly through direct-to-consumer sales, take them public with magic fairy dust (Groupon is worth $11.5 billion? Nice infinity multiple of EBITDA) and come home the conquering hero. Yes, people want and love these companies and their products; just try to tear someone away from Angry Birds.
But seriously people, we are not going to maintain world dominance because we are totally awesome at World of Warcraft, not to mention have access to Groupon’s wide world of super cheap pedicures. We can only re-establish our economic world dominance by having an economy to come home to. And if we don’t fix the healthcare system by changing the way we do things, we aren’t going to have that. So given the massive opportunity to bring companies to the fore to fix this problem, why are healthcare investors waving the white flag?
The primary reason given for why firms are running way from healthcare like Road Runner from Wile E. Coyote is the vastly more complex regulatory environment that has created a dark cloud over the biopharma and medical device industries. It is getting increasingly more difficult, more unpredictable and more expensive to get drugs or devices approved by the FDA. Over the last few years a trail of tears has been formed by companies that got surprised in the FDA process when they met their end points and still didn’t get approval or where the rules of the approval game were changed mid-field. Where many young U.S. companies didn’t even bother getting European regulatory approval in the past, now it is becoming the primary path to market. There is a rising crop of these companies that have decided never to seek U.S. regulatory approval, trying to make it by marketing only in countries where the FDA is not. Today’s regulatory environment is fraught with mistrust and confusion and it has had a real, measurable and negative impact on U.S. bio-medical dominance. Increasingly investment dollars are going overseas to China, India and elsewhere, taking with it the innovations that used to be ours alone. The net result of all this has been an environment where it costs far more and takes far longer than used to be the case to get a new drug or device to market in the U.S. These are two characteristics that those who invest in venture funds simply can’t stand–they want shorter time to liquidity, not longer; and they want a good return on investment, not an increasingly high cost to get to any outcome. As a result, money is drying up for those who specialize in biotech and medical devices and thus funds are wrapping up instead of bulking up.
A second but important issue is the advent of much greater scrutiny around what drugs and devices can get reimbursed in our public and private insurance systems. Even if you can get a regulatory approval, you may never see the light of day on getting payment for what you have to offer. It has always been challenging to get a new reimbursement code for a new product, but now it is becoming an act of God. For very good reasons payers don’t want to open the floodgates to new products that might simply increase costs further and add no meaningful clinical value. Purveyors of new products are being forced to make a strong economic case to get coverage for their drugs and devices, which further complicates the ability of new companies to get traction. It is very hard to build your real life economic case when you can’t get the product paid for to begin with, companies will argue. Frankly, it is hard to argue with the payers’ orientation, as the biotech and medtech focus has too long been on technology and not on value. However, there is a fine line between “prove it is worth paying for” and “when hell freezes over” and the latter is becoming the more dominant theme on the reimbursement front.
Some argue that all of the money fleeing biopharma and medtech is heading for the unregulated parts of healthcare, such as healthcare IT and healthcare services. There is a small bit of truth to that as healthcare IT, in particular, has become flavor of the month. But the amount of money rolling into healthcare IT is no where near that being displaced in the biotech/medtech side of the market and, oh by the way, the FDA has initiated processes to regulate healthcare IT, so nice try folks. This adds to why many venture investors are getting out of healthcare faster than Rick Perry’s backers are fleeing his campaign….oops!
The federal government should be very uncomfortable seeing the flight from healthcare investing. They are the ones leading the charge for change in the healthcare system but clearly they are not the ones who will create the innovations that satisfy their policy goals. If the government, whether it be the White House, the FDA, CMS, the Treasury or the Congress, doesn’t recognize that its policies are flattening the innovation curve, they are going to be left with a sorry mess where healthcare costs continue to double every 10 years, eventually eating up the entire GDP. Rather than take an adversarial regulatory, tax, hiring stance, the government needs to find ways to work hand-in-hand with industry to ensure that the healthcare goals they have set out can be met through the delivery of new products and services. If you kill the source of innovation now (venture capital and entrepreneurship go hand in hand), there will be no new ideas to implement 2-5-10 years from now when the rubber really hits the road.
Thankfully, there are still a few of us stalwarts (fools?) left who continue to believe there is real money to be made by investing in innovation in the healthcare system. A few of us are even crazy enough to continue investing in medical devices or biopharma, although the criteria to get funded are definitely more complex than in days gone by. Clinical efficacy, capital efficiency and evidence of real value to patients, payers and providers are the yardsticks by which these new investments must be measured if they are to have a chance in today’s increasingly complex healthcare economy.
So far this year only $264 million has been invested in venture-backed healthcare services deals as compared to over $5.5 billion in biotech/medtech; healthcare IT doesn’t even merit its own category in the PriceWaterhouseCoopers survey that tracks these things. It is definitely worth noting that the biggest challenges impeding the health our healthcare system are in the areas of how services are delivered and how technology could improve those functions. Thus one can hope that the investors that invest in venture funds will see the great opportunity, and thus great returns, that can be made by supporting innovation in these subsectors.
Furthermore, there are a lot of contrarians out there who make it their business to invest heavily in the areas from which everybody else is running away. Sometimes this doesn’t work out—I wouldn’t want to be investing in in horse-drawn carriages right now while everyone is standing in line to buy a Fisker—but when it comes to the healthcare economy, you gotta believe people are going to keep getting older, sicker, and needier of services no matter what else is happening out there in the world or how annoying the FDA may be. Thus I hope our industry begins to benefits from the wisdom of the contrarians, who must recognize the vast investment opportunity presented by an industry under dramatic transformation.
In Michael Lewis’ recent book, The Big Short, he writes about Charlie Ledley, a money manager who made out like a bandit while the financial markets collapsed, murdering the majority of the investment community. He writes that Ledley “was odd in his belief that the best way to make money on Wall Street was to seek out whatever it was that Wall Street believed was least likely to happen, and bet on its happening. Charlie and his partners had done this often enough, and had had enough success, to know that the markets were predisposed to underestimating the likelihood of dramatic change.”
While investors must be prudent about the risks inherent in investing in the healthcare marketplace, I think it is worth considering this thesis. The healthcare marketplace will undoubtedly look far differently 10 years from now than it does today given all of the changes underway. As the Age Wave crashes over our country, we will need the next generation of drugs, devices, services and technologies that can effectively serve the needs of our population. Those who are there with innovations that grease the wheels of progress will be tomorrow’s Charlie Ledleys.
John F. Kennedy once said, “Change is the law of life. And those who look only to the past or present are certain to miss the future.” Let’s hope that the government can remember that their actions today will result in outcomes for tomorrow. Moreover, let’s pray that the venture capital community and its backers can heed JFK’s words and hang in there long enough to reap the benefits of building tomorrow’s U.S. healthcare economy.